Peg Recovery Mechanism

The primary economic engine for peg recovery, leveraging market participants to correct price deviations. When a stablecoin trades below its peg (de-peg), arbitrageurs can buy the discounted asset and redeem it for the full value of the underlying collateral, profiting from the difference and reducing supply. Conversely, if it trades above peg, they can mint new tokens by depositing collateral and sell them at a premium, increasing supply. This mechanism is fundamental to collateralized and algorithmic models.

The process of adjusting the quality, quantity, or type of assets backing the stablecoin to maintain or restore the peg. Key actions include:

• Recollateralization: Adding more collateral to an undercollateralized position to restore the required backing ratio.
• Collateral Swaps: Exchanging riskier collateral (e.g., volatile crypto) for more stable assets (e.g., US Treasuries) to improve backing quality.
• Liquidation: Automatically selling a user's collateral if its value falls below a threshold, protecting the system's solvency. Used by overcollateralized protocols like MakerDAO.

The ability of a protocol to programmatically expand or contract the token supply in response to market demand to target the peg. This is the hallmark of algorithmic stablecoins (without direct collateral backing).

• Expansion (Minting): When price > $1, the protocol mints and sells new tokens, increasing supply to push the price down.
• Contraction (Burning): When price < $1, the protocol buys back and burns tokens, reducing supply to push the price up. This relies on seigniorage shares or bonding mechanisms to absorb volatility.

Direct intervention by the protocol or its governing DAO in open markets to defend the peg. This mimics central bank operations.

• Market Making: Using protocol-owned liquidity (e.g., in a DEX pool) to stabilize the buy/sell spread.
• Direct Buybacks: Using treasury funds or reserve assets to purchase the stablecoin off the market when it is below peg, creating buy-side pressure.
• Yield Incentives: Offering high rewards for providing liquidity in peg-stabilizing pools (e.g., Curve Finance's gauge weights) to deepen liquidity and reduce slippage.

The decentralized process of updating protocol parameters to optimize peg stability. This is a meta-recovery mechanism where token holders vote to change the rules of the system.

• Adjusting Fees: Modifying minting, redemption, or stability fees to incentivize or disincentivize certain actions.
• Changing Collateral Ratios: Updating the minimum required collateralization percentage for loans.
• Altering Algorithmic Parameters: Tweaking expansion/contraction rates, price oracles, or liquidation penalties in response to market conditions.

The guaranteed right for users to exchange the stablecoin for its underlying assets at the peg price, creating a hard price floor or ceiling. This is a direct, non-speculative path to peg recovery.

• Direct Redemption: 1:1 exchange for the underlying collateral (e.g., USDC for USD in a bank account).
• Protocol Redemption: Burning the stablecoin to claim a pro-rata share of the protocol's collateral basket, as seen in fractionally-algorithmic models like Frax Finance.
• Fixed-Price Redemption: A promise by the protocol to buy back tokens at a set price (e.g., $0.99) to establish a lower-bound support level.

A supply-adjustment mechanism where the protocol algorithmically expands or contracts the token supply to influence its price. When the price is below peg, tokens are burned to create scarcity; when above peg, new tokens are minted and sold. This is a core feature of non-collateralized or fractionally-collateralized algorithmic stablecoins. Example: The original Ampleforth protocol adjusted all holders' balances daily based on oracle price feeds.

A mechanism that creates profitable opportunities for arbitrageurs to correct the peg. The protocol sets a redemption price (e.g., $1) that differs from the market price, allowing users to profit by minting or redeeming tokens. Key components:

• Minting arbitrage: If price > $1, users mint cheaply against collateral and sell on the market.
• Redemption arbitrage: If price < $1, users buy tokens cheaply and redeem them for >$1 worth of collateral. This is fundamental to collateralized designs like MakerDAO's DAI.

A capital buffer of on-chain assets used to directly buy back and burn depegged tokens or to absorb redemption demands. The fund is typically filled with protocol revenue (e.g., stability fees) or seigniorage. How it works:

• When price < peg, the fund's capital is used in an automatic market operation to purchase tokens from the market.
• This reduces circulating supply and increases buy-side pressure. Example: Frax Finance's AMO (Algorithmic Market Operations Controller) uses part of its treasury to execute these stabilizing trades.

A mechanism where the target peg itself is adjustable based on market conditions or protocol health, rather than rigidly defending a fixed price. This is often used as a circuit breaker to prevent death spirals in algorithmic models. Implementation:

• The protocol may temporarily lower its target (e.g., to $0.90) to reduce redemption pressure.
• It can then gradually re-peg back to $1 as stability returns. This approach trades short-term peg accuracy for long-term protocol survivability.

The use of deep, centralized liquidity pools (often on major DEXs or CEXs) as a secondary defense line. The protocol or its governing DAO actively manages liquidity provision to narrow the bid-ask spread and absorb large trades. Key actions:

• Providing concentrated liquidity around the peg price on AMMs like Uniswap V3.
• Using treasury funds for open market operations on centralized exchanges. This mechanism complements on-chain arbitrage by improving market depth.

A manual, discretionary mechanism where token holders or a multisig council vote to enact emergency measures. This is a last-resort option when automated systems are insufficient. Possible actions include:

• Changing core parameters (e.g., stability fee, collateral ratio).
• Authorizing large-scale treasury expenditures for buybacks.
• Initiating a protocol upgrade or migration. Example: The MakerDAO Emergency Shutdown process, which allows MKR holders to settle the system at a fixed collateral price.

UST's mechanism relied on a burn-mint equilibrium with its governance token, LUNA. To recover from a depeg below $1:

• 1 UST could be burned to mint $1 worth of LUNA.
• This arbitrage was designed to reduce UST supply. However, during the May 2022 crisis, hyperinflationary minting of LUNA led to a death spiral, collapsing both assets and demonstrating the critical failure mode of a purely algorithmic, non-collateralized design.

The most common recovery mechanism uses arbitrage to correct price deviations. When an asset trades below its peg (e.g., 1 DAI = $0.98), the protocol allows users to redeem it for $1 worth of underlying collateral, creating a risk-free profit. This buying pressure pushes the price back to $1. Conversely, if it trades above peg, users can mint new tokens by depositing $1 of collateral and sell them for a profit.

• Example: MakerDAO's DAI Savings Rate (DSR) adjusts to incentivize holding or minting DAI.
• Risk: Requires sufficient liquidity and low transaction costs for arbitrage to be effective.

Protocols can actively manage their collateral portfolio to defend the peg. If an asset is undercollateralized and depegs, the system may trigger collateral auctions to sell excess assets and buy back the stablecoin, burning it to reduce supply.

• Example: MakerDAO's Surplus Auctions use protocol revenue (stability fees) to buy and burn MKR or DAI.
• Emergency Shutdown: A last-resort mechanism where the system freezes and settles all positions at a fixed collateral ratio, allowing users to claim their share of the backing assets directly.

Algorithmic stablecoins (e.g., Ampleforth, older versions of Terra's UST) use supply elasticity. The protocol's smart contract automatically adjusts the token supply in all wallets—expanding it when price is above peg and contracting it when below.

• Rebase: A wallet holding 100 tokens might see its balance change to 95 tokens after a negative rebase, with each token now targeting a higher value.
• Critical Risk: This model relies solely on market expectations and can enter death spirals if contraction fails to restore demand, as seen in the UST collapse.

Many protocols embed recovery tools controlled by decentralized governance. Token holders vote to adjust key parameters like stability fees, collateral ratios, or to deploy treasury funds for direct market operations.

• Example: A DAO might vote to use its protocol-owned liquidity in a Curve pool to directly buy back its depegged asset.
• Risk: Governance attacks or voter apathy can delay critical interventions, exacerbating a crisis. Response time is not automated.

All peg recovery mechanisms carry systemic risks:

• Collateral Volatility: If backing assets (e.g., other crypto) crash simultaneously, the peg defense can fail.
• Liquidity Black Holes: A severe depeg can drain all protocol-owned or pooled liquidity before recovery kicks in.
• Reflexivity: Negative price action can trigger mass redemptions, leading to a bank run that overwhelms the mechanism.
• Oracle Manipulation: If the price feed determining the peg is compromised, the recovery logic will fail or be exploited.

The collateralization ratio is the value of assets backing a stablecoin or pegged asset relative to its total supply. It is a critical health metric for over-collateralized systems.

• Over-collateralization: Assets exceed liabilities (e.g., 150% ratio) to absorb price volatility.
• Minimum Collateral Ratio: The threshold below which a position is liquidated to protect the peg.
• Example: A vault with $150 of ETH backing $100 of a stablecoin has a 150% collateralization ratio.

Arbitrage is the simultaneous buying and selling of an asset in different markets to profit from price discrepancies. It is the primary economic force that drives most algorithmic pegs back to their target.

• How it works: When a stablecoin trades below $1, arbitrageurs buy the cheap stablecoin and redeem it for $1 worth of underlying collateral, profiting from the difference.
• This activity increases demand for the stablecoin, pushing its market price back toward the peg.

Seigniorage refers to the profit made by the issuer of a currency from the difference between its face value and production cost. In algorithmic stablecoins, it describes the system's ability to mint and burn tokens to manage supply.

• Expansion Phase: New tokens are minted when the price is above the peg, often distributed to stakeholders.
• Contraction Phase: Tokens are bought and burned when the price is below the peg, reducing supply.
• This mint/burn mechanism is a core peg stability tool for assets like the original Basis Cash or Empty Set Dollar.

A liquidation is the forced closure of an under-collateralized debt position in a lending or stablecoin protocol. It is a defensive mechanism to protect the system's solvency and the peg.

• Trigger: Occurs when a vault's collateralization ratio falls below a predefined minimum.
• Process: The protocol automatically sells the collateral, often at a discount, to repay the debt and maintain the asset's backing.
• This process is fundamental to the stability of protocols like MakerDAO (DAI) and Liquity (LUSD).

A redemption mechanism allows users to directly exchange a pegged asset (like a stablecoin) for its underlying collateral or a basket of assets at the peg value. It creates a hard price floor.

• Direct Peg Support: Provides a guaranteed exit at $1, which anchors the market price.
• Types: Can be 1:1 for fully-backed assets (USDC) or at a variable rate for algorithmic systems (Frax).
• This mechanism is often the final backstop in a peg recovery system, as seen in MakerDAO's PSM or Frax Finance.